Inflation can play havoc with savings – which is why many savers are attracted
to index-linked accounts.

Savers are ploughing millions of pounds into inflation-linked investments that promise to deliver risk-free real returns.

Given that inflation is still running at 5pc a year – more than twice the Government's target – it is not hard to see why these products are proving so popular.

But with both official measures of inflation falling this week, there are suggestions that it may have peaked. If so, does it make sense for consumers to lock their money into long-term savings accounts?

Santander, the Post Office, Yorkshire Building Society, Legal & General and Birmingham Midshires (now known as BM Savings) are among the companies that have offered such products in recent months.

All are fixed-term savings plans requiring customers to lock their money away for between three and six years. These products attempt to plug the gap left by National Savings & Investments' Index-Linked Savings Certificates, which were withdrawn from sale in September. But the newer products are pale imitations, offering lower returns, less flexibility and in some cases more risk than the original N S & I "linkers".

There are also concerns that – once again – ordinary investors are piling into a product at the wrong time. Obviously inflation has been a problem over the past few years. According to Moneyfacts, a £10,000 cash deposit made five years ago is worth just £9,239 today – even with "average" interest added. And with the retail prices index at 5.4pc, the value of people's savings would effectively halve in a little over 12 years, although few economists expect the RPI to remain at this level for this period of time.

But the questions for savers are: do they need to inflation-proof their savings? And, if so, what is the best product for them?

Do you need an index-linked account?

No bank or building society pays enough interest to beat inflation. So index-linked accounts can seem the only option for those who don't want their savings to fall in real terms and aren't prepared to risk their capital.

But Andrew Hagger of Moneynet.co.uk said: "The conundrum is that even though these products protect you against inflation, they don't guarantee the best return."

If inflation slows, the returns paid could easily be beaten by some of the better-paying fixed-rate deals. Yorkshire Bank pays 4.7pc fixed, while the Post Office pays RPI plus 1 percentage point on its five-year account. If prices rise by just 2pc a year over the next five years, the Post Office will pay just 3pc – less than the Yorkshire deal.

But none of us has a crystal ball to predict what will happen with inflation. While some economists, such as Capital Economics, say inflation has now passed its peak, others are concerned about commodity price rises and quantitative easing (printing money).

Mr Hagger added: "While inflation is predicted to drop back sharply in the first part of 2012, the longer-term picture is less clear. Sharp falls in inflation are unlikely to be mirrored by falls in savings rates, so a mix of index-linked and standard fixed-rate products may be a more sensible strategy."

How do these products work?

They are "structured" savings products that require savers to lock up their money for three to six years. All offer a return based on the RPI, paid at the end of the term.

The Post Office's three-year inflation-linked bond, for example, pays RPI plus 0.25 percentage points. A list of products, and their terms, is given in the table above.

Remember, it is the difference in the cost of living – as measured by the RPI – between when the bond is opened and when it matures that is key. The fact that RPI is 5.4pc today is irrelevant, as this is the increase in prices between October 2010 and October 2011. It is the increase in prices over the next year (and subsequent years) that will determine your return.

Term

David Black of Defaqto said investors should look first at the term of a product and avoid it if they may need to withdraw their cash sooner, as they will face hefty penalties.

Tax

The next question is whether returns are tax-free. Both Yorkshire Building Society and BM Savings allow investment through a cash Isa. The Post Office and Santander do not. While an Isa limits how much you can save a year – this year the maximum is £5,340 – it ensures that returns are tax-free. For higher-rate taxpayers, this is likely to mean a better return even if the headline rate does not appear to be so generous.

However, if you want to save more, the Post Office option allows a maximum deposit of up to £1m. Remember that after tax is deducted this is likely to mean the overall return is less than inflation.

Security

Savers should also consider the security of such plans. All of those currently offered by high street lenders are "structured deposits" so will be fully covered by the Financial Services Compensation Scheme up to its maximum £85,000 limit should either the bank selling the product or any counterparty backing it run into difficulties.

This is important. Some financial advisers sell "structured investments" which may appear similar, but your capital could be at risk if an investment bank backing the product fails, or if an inflation or equity index to which it is linked falls in value.

Returns

If you have the right term, tax treatment and protection, now you can calculate which account offers the best return. If you think inflation will slow, L & G's deal is attractive, as it pays either RPI or 3.27pc a year e_SEnD whichever is greater. But if RPI remains high the Post Office will deliver a better return. All bonds will return your capital (some pay interest on top) if inflation falls into negative territory. The table shows product returns in various inflationary environments.